Overbought market conditions persist

Commentary: ‘Overbought’ is not a sell signal; market can go higher

LawrenceG. McMillan

Columnist

MORRISTOWN, N.J. (MarketWatch) — The stock market continues to rise in a slow-motion fashion. The rise has been so uniform, but dampened, that daily extremes have not been reached.

However, more intermediate-term indicators are now overbought. “Overbought” doesn't mean sell, though. In fact, a market can continue to rise strongly during an overbought condition (such as the current one), just as it can fall sharply even though it is “oversold” (witness the fall of 2008, for example). Hence, bulls can enjoy the rise, while potential bears and other sellers must await an actual break of the uptrend before taking action.

The Standard & Poors 500 Index
SPX, -0.55%
is setting records this January, as it has already risen 5.7% this month. The rise has been steadily and unspectacular. SPX is now trading at its highest levels since December 2007. The all times highs of October 2007, at 1,576 are now in sight, although there is some resistance at 1,520. If an overbought correction does materialize — as it well might — there should be support in the 1,460-1,470 area.

The equity-only put-call ratios, which are generally very good intermediate-term technical indicators, are struggling to find a trend in this market. These ratios have been wavering back and forth at relatively low levels on their charts. The low levels indicate an overbought condition, but the lack of trend is due to a battle between call buyers (following the trend of the market) and put buyers (traders buying cheap puts for protection).

These buyers of cheap puts are hedgers; I doubt they are negative on the market. Rather, they own stocks and they own puts. They would prefer that stocks continue to rise. However, their put-buying activity has become quite voluminous of late since puts are cheap and since many pundits are recommending that puts be bought for protection. As a result, they are distorting the put-call ratios to some extent. These put-call ratios work best when speculative trading can be isolated; hedging distorts them. Thus, they are somewhat distorted right now. Once a clear trend redevelops, they will be more useful again.

Market breadth has been strong during this rally. As a result, our breadth indicators are on buy signals. However, they are also overbought, as the accumulation of daily advances over declines has gotten too be too overpowering. This market is a classic example of the fact that an emerging bullish trend can feed off of overbought conditions. What is also amazing is that there hasn’t been a single “90% up day” since Jan. 2 — which was the day after congress avoided the fiscal cliff. Hence, the buying this month has been steady but not overdone. That is probably why it has been able to continue for so long.

Volatility indexes
VIX, -2.82%VXO, +0.05%
are extremely low and seem to show no signs of expanding. As long as VIX continues to close below 14, it is considered bullish for stocks. VIX recently closed at the lowest levels since May 2007. But then VIX was on its way up from lows around 10, while now it is on its way down. Hopefully, VIX won’t get down to 10 again, because the market is boring at that volatility.

Other volatility measures are in agreement: the Composite Implied Volatility (CIV) of all stock options shows that the average stock’s options are in the sixth percentile of implied volatility. That, too, is very low (overbought), but as long as it stays down there, stocks can continue to rally (a sell signal would be generated if the CIV rose to the 17th percentile, which seems like miles away at this point).

The low levels of VIX have contributed to a bullish construct in the VIX futures. That is the futures are trading with sizable premiums to VIX itself, and the term structure of the VIX futures continues to slope steeply upward. Some argue that the fact that longer-term VIX futures are trading with large premiums means that “smart” money thinks there will be a large jump in volatility six to eight months from now. That is not true. Rather, with VIX at such low levels, it is quite natural for the term structure to slope steeply upward.

It doesn’t mean traders are bearish; rather, it merely means that market makers and traders are pricing longer-term SPX options with implied volatilities closer to average volatility levels. The longer term an option is, the more likely it is implied volatility is predicted to be near its long term average volatility. That is just a function of market making and option pricing and has nothing to do with a prediction of a volatility explosion at some longer term future date.

In summary, it may be tempting to short this market or to at least try to catch a short-term correction, because of the massive overbought conditions. However, until there is some break in the trend — either in price of in volatility — it will likely not pay to bet against the trend. For example, SPX hasn't closed below a previous day’s low all year. One should at least wait for that to happen before trying to time a sell in this market. Also, until volatility starts to pick up, there won’t be a trading correction, either.

At a minimum VIX would have to close above 14 in order to give sellers some hope. Lacking that, the bulls will continue to push this market higher.

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